by Peter Schiff, Schiff Gold:

In the most recent Friday Gold Wrap podcast, Mike Maharrey talked about the fact that the Federal Reserve has increasingly engaged in more and more extraordinary monetary policy. As he put it, extreme has become the norm. Despite what pundits insist is a “great” economy, interest rates are extremely low by historical standards and the Fed is engaging in quantitative easing to the tune of $60 billion a month.

While stock markets continue to make record highs and the economy continues to grow, the question is how long can this last?

Peter Schiff has been saying that this is an inflation-driven bubble and it’s going to pop. But even Peter admits that the Fed has managed to keep the bubbles inflated a lot longer than he expected it could.

Some in the mainstream have suggested that the era of booms and busts is over — that the central banks have figured out how to maintain a perpetual boom. But as economist Thorsten Polleit explains, this notion defies economic reality. The central banks may have pushed the inevitable crash down the road, but the era of boom-bust is not over.

The following was written by Thorsten Polleit and originally published at the Mises Wire.

At the 2020 World Economic Forum in Davos, Bob Prince, co-chief investment officer at Bridgewater Associates, attracted attention when he suggested in a news interview that the boom and bust cycle as we have come to know it in the last decades may have ended. This viewpoint may well have been encouraged by the fact that the latest economic upswing (“boom”) has been going for around a decade and that an end is not in sight as suggested by incoming macro- and microeconomic data.

But would that not reject the key insight of the Austrian business cycle theory (ABCT), which says that a boom, brought about by artificially lowered market interest rates and injections of new credit and money produced “out of thin air,” must eventually end in a bust? In what follows, I will remind us of the key message of the ABCT and outline the “special conditions” which must be taken into account if the ABCT is applied to real-world developments. Against this backdrop, we can then form a view about how the next crisis might look.

What the ABCT Says

The ABCT is actually a “theory of crisis,” and it explains the broader consequences if and when central banks, in close cooperation with commercial banks, increase the amount of money in the economy through credit expansion—that is, an increase in bank lending that is not backed by real savings. The increase in the circulation of credit supply initially lowers the market interest rate below its “natural level,” or, “the originary interest rate level,” to use the Austrian school’s term.

The artificially lowered market interest rate discourages savings and encourages consumption and investment expansion. The economy enters a boom. However, after the initial injection of new credit and money has had its impact on prices and wages, people start realizing that the economic expansion was a one-off. People return to their pre-boom savings-consumption-investment ratio, which means that the market interest rate finally returns to the higher originary interest rate level. This is the very process that makes the boom turn to bust.

To prevent the boom from turning to bust, central banks take action to bring down market interest rates even further. If the market interest rate drops even more, the production and employment structure can be upheld and the boom can continue. In other words: the trajectory of market interest rates—which are actually expressive of how people allocate their incomes to savings, consumption, and investment—is the crucial issue in the boom-and-bust cycle. And this is where central banks have increasingly taken control.

Controlling Interest Rates

Since the financial and economic crisis of 2008/2009, central banks have more than ever before taken control of market interest rates. They no longer limit themselves to setting short-term interest rates, but hope also to control interest rates with longer maturities. In fact, central banks have started to set long-term interest rates as well, through purchasing, say, government bonds, mortgage bonds, corporate bonds, and bank bonds. In this way, they directly influence bond prices and thus their yields. Market interest rates are no longer determined in a “free market.”

Not only have market interest rates been distorted and set at too low a level through central bank policies, they are also kept from returning to economically sensible levels. At least this is what financial market agents seem to think: they assume that central banks will continue to take care of the credit market—they know that if and when market interest rates rise, the boom will undoubtedly turn into a bust, something central banks wish to prevent at all costs.

And given the basically unlimited power of central banks in the determination of bond prices and thus bond yields, no investor (in his right mind) will want to bet against the monetary authority. In fact, investors have a great incentive to trade bond prices toward the level they think the central bank would like to establish in the marketplace. In other words: if the market thinks that the central bank does not want higher interest rates, interest rates will remain artificially low.

Mind the “Safety Net”

By controlling market interest rates, central banks have in fact put a “safety net” under the economies and financial markets. As central banks have signaled to the public that they feel responsible for a healthy economy, and, in particular, for ensuring that “financial market stability” prevails, investors can put two and two together: should the economies or financial markets get to the verge of collapse, investors can expect central banks to step in, fighting the impending crisis. This understanding encourages investors to take additional risks, step up their investments, and disregard and underestimate risk.

Central banks’ “safety net” is not only a powerful tool to sustain the boom, it is also a rather subtle, stealthy intervention in capital markets. It effectively brings about an entirely rigged financial market: prices are higher and yields are lower than unhampered market forces justify. The central banks’ safety net policies amount to a manipulation of the market system on the greatest scale possible. With basically all prices and all market yields distorted, the economy and financial markets enter a “hall of mirrors” regime, where consumers and firms must inevitably get disoriented and make wrong decisions.

However, under such conditions the boom can be kept going much longer compared to a scenario in which free-market forces are allowed to do their job—that is, establishing financial asset prices as well as inflation, credit, and liquidity premia according to real-world realities. However, today’s environment is rather different: central banks, in their attempt to prevent the current boom turning into another bust, have effectively corrupted the vital roles that financial markets and market interest rates play in a free market system.

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